Discussion Paper: Are Analysts Providing Measurable ‘Added-Value’?

Once companies have provided financial guidance: Are analysts’ forecasts
able to add any extra value? If so, how often and by how much?

A study by AKRO
investiční společnost, comparing the accuracy of analyst forecasts and
management forecasts, shows that so called ‘post event’ analyst forecasts, i.e.
those made post recent results/management guidance, are in general more
accurate than management forecasts. Both the frequency and magnitude of the
greater accuracy prove significant, a somewhat reassuring conclusion for
research analysts.

If analysts are
able to provide insights with regard to tangible measures of value, it seems
logical to assume analysts are also able to provide insights with regard to
less tangible measures of value, e.g. management quality, industry outlook. At
a time when the ‘active’ asset management industry is getting a bad press, and
many research departments are being downsized[i],
the results should give pause for thought.

Analysts’ Forecasts ‘Closer to the Mark’ More Often…

The study compared
the accuracy of annual forecasts for constituents of the Japanese Nikkei 225
index, over an eleven year period, between the years 2006-2016. The study took
advantage of an interesting feature of the Japanese equity market, whereby
listed companies provide updated annual forecasts whenever they release their
quarterly results.

Source: Bloomberg
Earnings/ AKRO investiční společnost, a.s.

Nb. Over the 11
year period there are potentially 2475 (225x11) comparatives for each measure.
Comparatives were made only when there was both a management forecast and a
‘post event’ analyst consensus prior to the final results being released.

Two measures of
forecast accuracy were examined. The first measure simply compared the
frequency with which ‘post event’ analyst forecasts proved more accurate than
management guidance. Four key forecast variables were analysed: Sales,
Operating Income, Net Income and EPS. A summary of the results are presented in
Table: 1. Regardless of which item on the P&L account was being forecast,
‘post event’ analyst forecasts turn out to be closer to the final result
significantly more often than management forecasts. Overall, analyst forecasts
were closer on 57% of occasions, management on 39% of occasions while
comparable accuracy was recorded on 4% of occasions. With the occasional
exception, this bias in favour of analysts’ forecasts persisted over the entire
period of the study.

…And By a Significant Margin

The second measure
of forecast accuracy looked at the percentage the reported result deviated from
forecast: Sometimes referred to as the degree of ‘surprise’. The lower the
percentage deviation, the more accurate was the forecast.

Source: Bloomberg
Earnings/ AKRO investiční společnost, a.s.

Forecasts which are
more accurate, i.e. lower median percentage deviation, than management
guidance, are highlighted in green.

The median
percentage deviation of forecasts from the actual result, the level of surprise,
is shown in table 2. For example, in terms of sales forecasts, the median
percentage surprise was 0.87% for management forecasts, 0.86% for the
‘standard’ consensus forecast, and 0.73% for the ‘post event’ consensus. What
is most striking from the table is that, whatever the P&L item, the ‘post
event’ consensus is the most accurate predictor (lowest percentage deviation)
of the final result, more accurate than either the ‘standard’ consensus or
management forecasts. It is also clear that as one moves down the income
statement, while the overall forecasting accuracy diminishes, the degree of
‘value-add’ analysts provide increases. For example, the median level of
surprise for management forecasts of earnings per share (EPS) is 7.43% compared
with 6.18% (a difference of 1¼%) for analysts’ ‘post-event’ forecasts.

This difference in
forecast accuracy is really quite large: Remember, we are comparing the
accuracy of forecasts prior to the announcement of the final results. With
results for the first 9 months already announced, the 1 ¼ % difference in
forecast accuracy for the 12 month results must come about in the final 3
months of the year. To illustrate this point, assuming there is no seasonality
in the quarterly results, for the analysts’ 12 month eps forecasts to be 1 ¼ %
more accurate, their forecasts for the final quarter must be approximately 5%
(1¼% x 4)more accurate than those implied by the management forecast. A really
impressive result!

2.Where no ‘post event’ forecasts are available,
investors should focus on company guidance.

3.Least accurate are forecasts made prior to recent
results/guidance.Where possible these
‘out-of-date’ forecasts should be completely excluded as they materially
detract from forecast accuracy[ii].

These common sense
findings call into question the widespread use of ‘standard’ consensus forecasts.
In table 2, the ‘standard’ consensus (which also includes older forecasts) is
shown as significantly less accurate than the ‘post event’ consensus. In other
words, the timeliness of forecasts is more important than the inclusion of a
large number of forecasts. Part of the problem may be brokers’ willingness to
publish forecasts even when they are blatantly out of date. In this context,
‘Post event’ consensus forecasts, compiled by information providers, by
excluding ‘out of date’ estimates[iii],
in fact provide considerable value-added. The findings also suggest, not
unrealistically, that research has most potential for value-added when directed
to ‘neglected’ stocks with no recent broker estimates.

Research Matters

At a time when
‘passive’ investing is in vogue, the study provides tangible evidence of the
‘value-added’ research analysts provide. Whilst forecasting results is but one
tiny aspect of investment research, it is both tangible and measurable. That
analysts can add-value with regard to financial forecasts is reassuring and
probably means that analysts are also able to provide insights with regard to
less tangible areas of valuation, e.g. competitive position, environmental
responsibility, management quality, riskiness. In other words, scarce capital
can be more efficiently allocated due to the efforts of research analysts.

Despite the added
value which research clearly provides, the ‘revelation’ that the average
investor cannot outperform the average investor has led many investors to
abandon research-based investment in favour of low cost passive index based
investment. As investment groups struggle to justify paying for research, the
recent ‘unbundling ‘of research from commissions has, the author suspects,
hastened this trend towards ‘dumbing down’ investment decisions. We have
populated the investment universe with Lemmings, self-assured that they are no
more a Lemming than other Lemmings and implicitly relying on the efforts of
fewer and fewer genuinely active investors. Can we sleep soundly at night based
on that premise?

Is There Anyone Left to Warn? Look Out!!!! There’s a Cliff Ahead!!!!

The Cost of Dumb Investment

There is, however,
a hidden cost to the move away from fundamentally driven investment and it is a
cost ultimately borne by society as a whole. Capital allocated on the basis of
little or no fundamental research is more likely than not to be capital
misallocated and we will all pay the price for that.

Poor capital
allocation ultimately leads to lower growth in economic activity and more
extreme economic cycles. It is difficult to see how an increasingly ‘research lite’
investment environment possibly helps. Chart 1 shows the trend in US nominal
GDP since the end of WW2. Since the start of the 2008/9 financial crisis,
nominal GDP has been markedly below trend. Indeed, if you believe that the
stock market should reflect trends in underlying economy, the current valuation
of the US S&P500 index needs to drop almost -44% to bring it back in line
with GDP. In 2000 and 2007, the figures were -54% and –36% respectively. If
investors had allocated capital more wisely, current levels of GDP would be
much closer to trend (dashed line) and the stock market’s current valuation
would look much less stretched.

Chart 1: ‘’Mind the Gap’’ Nominal GDP, Trend GDP, and the US S&P500
Index Since 1947

Source: AKRO
investiční společnost, a.s./Bloomberg

Nor is the
deviation of GDP growth from its long-term trend just because of low inflation.
Today’s somewhat deflationary environment is, of course, itself a consequence
of poor investment decisions made prior to the 2000 dot-com bust and the 2007/8
crisis, e.g. reckless investing/ bank lending. However, even adjusting for
inflation, there has been a step change down in the rate of GDP growth Chart 2).

Chart 2: Growth in US Real GDP Has Moved Down a Gear

Source: AKRO investiční
společnost, a.s./Bloomberg

Would more research
based investment have prevented the financial crisis? Quite possibly. Investing
on the basis of index membership or partial 3rd party analysis
(rating agencies, issuing banks) can never be a substitute for investment based
on critical independent research.

One example, of
such research, would be Terry Smith’s ‘’Accounting for Growth’’, 1992. A book,
at the time both widely praised and condemned, which highlighted the aggressive
accounting practices of many leading British companies. Should similarly
well-argued research have appeared before the 2000 bust or the 2008/9 crisis,
the economic consequences would have been profoundly positive. Instead, twice
within the space of a decade, we witnessed capital destruction on a massive
scale. Even relatively small insights, at the industry or corporate level,
should therefore be encouraged.

With hindsight, investment
blunders are generally avoidable and foreseeable. Analysts can add valuable
insights but we need to promote a climate of intelligent investment; not
today’s philosophy of scattergun investment. The investment industry should not
aim for mediocrity because, if it leads to poor capital allocation, ultimately
nobody benefits.

Diversification – No Free Lunch

If analysts, as our
study suggests, are able to provide valuable insights, why doesn’t this
translate into better performance? Some research suggests it does. Small
boutique investment firms, with high conviction portfolios have, for example,
been shown to be able to generate above average returns[iv].However, for research based investment to
flourish more generally, three issues, which have undermined the active
management industry, need to be addressed: over-diversification, short-term
investment horizons and low risk tolerances.

Until these issues
are tackled, the ‘active’ management industry will remain under pressure.

The author would
like to acknowledge the help of Sayo Ando, Takayuki Kutsuma and Beata
Wijeratne, Equities – Global Data, Bloomberg London/Tokyo Markets in compiling
the underlying data used in the study.

This article does not constitute
investment advice or a recommendation to buy or sell any security. The opinions
expressed in this article are the author’s and do not necessarily represent the
views of AKRO investiční společnost, a.s.

[ii]Ota, Hiroshi. 2005. Yoso rieki no seido to
kachi kanrensei: I/B/E/S, shikiho, keieisha yoso no hikaku (Accuracy of
earnings forecasts and the correlation to valuation: A comparison of forecasts
from I/B/E/S, Shikiho, and management guidance). Gendai Finance 28: 141-159.
Ota’s research highlighted the poor accuracy of consensus estimates compared
with management guidance.AKRO
investiční společnost’s research focused on comparing management forecasts with
‘post event’ forecasts. Excluded from the scope of the study were situations
where the consensus consisted of only ‘out of date’, i.e. pre-event, forecasts.
Visually inspecting the data shows that these were almost always less accurate
than a subsequent management forecast. Inclusion of these ‘consensus’
forecasts, which don’t include a single up-to-date forecast, would have
undoubtedly further reduced the overall accuracy the ‘standard’ consensus.

[iii]Bloomberg, for example, manually excludes those broker
analysts that provide ‘pre-guidance/old estimates’ even when the company revised
their estimates.

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